Apollo Commercial Real Estate Finance, Inc. (ARI) Q2 2012 Earnings Report, Transcript and Summary

And good morning to everybody, and thank you for joining us on the Apollo Commercial Real Estate Finance Inc. Second Quarter 2012 Earnings Call. Joining me this morning in New York are Scott Weiner, our Chief Investment Officer; and Megan Gaul, our Controller, who will review ARI's financial results after my remarks. The commercial real estate finance market maintained its moderate pace throughout the second quarter as capital continued to flow into the sector. The combination of the historically low interest rate environment, coupled with the large number of commercial mortgages reaching their stated maturities, has led to a modest uptick in property recapitalizations, particularly for stabilized cash flowing assets in primary markets. The conduit market has picked up its pace as reflected in the issuance -- as the increase in CMBS issuance over the quarter. For the first 6 months of the year, U.S. CMBS issuance was $18.2 billion as compared to $17.1 billion for the first 6 months of 2011. New issue spreads on benchmark bonds have been on a roller coaster ride this year, hitting the low of 105 basis points in early March and peaking at a 160 bps in late June. There has been some improvement in market pricing in recent weeks as fixed rate CMBS still seem relatively inexpensive next to comparable asset-back securities and corporate bonds. And we believe that new issuance in the CMBS market will continue at a measured pace for the remainder of the year. With respect to ARI, our focus remains on identifying debt investments on performing loans within our target asset classes. We continue to see a diversified range of opportunities across the board -- broad spectrum of property types and geography. In April, we acquired 2 senior sub-participation interests with an aggregate face value of $23.8 million,…

Thank you, Stuart. Before I discuss our financial results, I want to remind everyone that we have posted our supplemental financial information package on our website, which contains detailed information about the portfolio as well as ARI's financial performance. Turning to our financial results, for the quarter ended June 30, 2012, we announced operating earnings of $8.5 million or $0.41 per share, which represents a 2.5% increase over our operating earnings per share from the same period a year ago. This is driven by a 23% increase in net interest income, which rose to $12 million in the second quarter of 2012 from $9.7 million in the second quarter of 2011. For the 6 months ended June 30, 2012, the company reported operating earnings of $17.3 million or $0.83 per share, representing a per share increase of 20%, as compared with operating earnings of $12.1 million or $0.69 per share for the same period in 2011. A reconciliation of operating earnings and operating earnings per share to GAAP net income and GAAP net income per share can be found in our earnings release contained in the Investor Relations section of our website, www.apolloreit.com. It is worth noting that operating earnings for the second quarter included a few nonrecurring items. As Stuart mentioned, we recognized approximately $750,000 of brokerage and other fees related to the closing of the South Boston transaction. Separately, we recognized approximately $500,000 of income during the second quarter, resulting from a make-whole provision upon the repayment of a portion of our repurchase agreement investment. While both of these items were recognized in the second quarter, in accordance with GAAP, the additional fees and interest resulting from the loan modification that Stuart mentioned earlier, will be recognized over the remaining life of that loan. Turning to the balance…

[Operator Instructions] Your first question comes from Steve Delaney, with JMP Securities.

Stuart, it seems in the capital markets, there's been this mad rush for fixed income and for yield really in every sector. And you commented on CMBS spreads tightening, and it's happening all over. I was just curious if you could comment your, Scott, on the sort of your competitive landscape? Who are you running up against, maybe not specific names, but just the types of competitors? And given this rush for yield, you're seeing anyone becoming more aggressive on terms and pricing. So sounds like you've got a good pipeline, but I'm trying to get a sense for whether you're going to be still be a price setter, if you will, or is it becoming more of a price-taker type of market?

Scott, I think I'll answer that. Clearly, the products that are more, what I'll say, tradable on a Bloomberg, or if you will, or more that anyone kind of without real estate expertise of various hedge funds or other institutions can buy, those are clearly where you're seeing the greatest tightening. So the most liquid, obviously, CMBS means Hilton even for example, we bought it 94 3/8, it's now trading over 96. You don't have to be a real estate expert to do that. It pays, people make market, and people can do that where if you move the other end of the spectrum where one needs to do real estate underwriting, one needs to have an ability to diligence and close and document deals. That's where -- and it's more bespoke, that's what you see -- that's where you see more opportunities. You also see more opportunities on products that don't fit the securitization or really the capital market. So whether it be a first mortgage loan on condo inventory or lease-up property or even mezzanine deals we're doing, those are where we can really add value to the process, certainty of closing and understand the real estate and where you get more attractive yields than you would on just kind of a run-of-the-mill product that people make markets and in trades.

So Scott, it sounds like it's still very much the landscape you guys -- it's very specialized, and its mortgage REITs, specialized debt funds. You're not seeing, what I would call like, fast or macro-type money getting in the way?

No, actually not. I mean, again, in the last cycle, that was driven a lot by the CDO market, which again commoditized mezz and other products. We're not seeing that. I will say on the other part where we are seeing is clearly on the CMBS market that is where there are a lot of folks competing and getting more aggressive, which is why you don't see us doing many deals behind conduit loans, if you will. It's just not attractive. The one deal we closed in Chapel Hill was somewhat of a special deal. We really liked it. We thought it was well structured to get 10-year duration. That type of yield was attractive, but what we are seeing the conduits overall pushing more what they can put into their deals.

Yes, we'd heard that. Some of the easier mezz was getting squeezed out because the CMBS deals were being written a little more aggressively. And there wasn't as much need for the mezz behind CMBS.

Correct.

Your next question comes from Joshua Barber with Stifel, Nicolaus.

Would you be able to talk a little bit more about the Boston, the development loan there and I guess what the plans are in terms of any extension options? You guys bought it at, obviously, pretty decent discount, and it matures at the end of this year. Have you began any conversations with the borrower? Is there potential there to extend that loan, or do you expect it to pay off?

Yes, I mean I think we thought we wrote it pretty clearly. While the loan matures in December 2012, the borrower does have an extension option as a right -- by paying a small, I think it's a 0.5 fee, and there's some required amortization. So the borrower does have that right. What attracted to us was our basis, and clearly, the discount kind of generates 20 plus IRRs. That leverage is obviously attractive. Right now, it is cash flowing. We are well covered by the income coming off the parking garage. It is the borrower's intent to continue to sell off parcels to end users. Obviously, Boston, this part of Boston is going through a renaissance with biotech and other uses, so they've already sold off some parcels. And the type of uses is everything from multi-family, development, hotels, office, are all being developed there. And so over time, we would expect to see pay downs of the loan. Our IRR assumes they just make the required amortization at the end of this year, which pays us down a few million dollars, and then it goes all the way to the end of next year. We don't necessarily think that's the most likely scenario, but that's just the way we have to account for it. And I know they're in active discussions now to sell some parcels. They just haven't consummated them since we've closed.

That's very helpful. Can you also talk about what you're assuming on the Hilton loan for purposes of that underwriting? Because I don't think there's been a lot of talk about them potentially going public and having to basically get rid of that particular loan.

Yes, again, given the accounting standards, we've underwritten that based on the forward LIBOR curve both for our borrowings, which are floating rates, but also the loan and as soon as it goes out to full maturity. I think clearly Blackstone has sponsored -- given the capital structure here most likely we'll not wait for the last day to refinance this capital structure whether they go public. Obviously, there's a lot of speculation. So I think there's upside to the IRR from what we're showing given the discount, any kind of early repayment will improve the IRR. But for now, we're assuming it goes all the way out to full maturity.

Was that actually purchased at a discount?

Yes, and it's unmet. We purchased it, I think about 94 3/8. And like I said today, it's trading above 96. And for GAAP purposes, like the other AAA CMBS that we own, that change in market value will be reflected in our GAAP book value.

Your next question comes from Gabe Poggi with FBR.

Two quick questions. Scott, kind of piggybacking what you said earlier, answering Steve's question, has there been any generic tightening in mezz? Have you had -- I know that the market is still pretty specialized. There are not as much fast money in it. But it -- just on the margin, has there been any tightening for 75-ish LTV product? That's question one. Then question 2, Stuart, I don't know if you guys provided a timing for deployment from the preferred capital, if you guys have a scheduled timing you'd like to get that out the door, or just kind of hit pitches as you see them?

I would say on the first point, the type of mezz or preferred equity to ARI, so we really haven't seen tightening. I will say, we do manage money for an insurance company that does kind of lower leverage, lower return mezz. And we have seen some tightening in that market as insurance companies and others. Pension funds from others have come into that market. That's really a lower leverage kind of 60-ish percent leverage market. And you'll hear in MetLife and other insurance companies, as they look to go yield, you do see some shifting out from them doing first mortgages at 3% to kind of doing lower leverage mezz at 7%, call it. But again, that's kind of a different market than clearly what we're focused on at ARI.

I think, Gabe, from a timing perspective, the preferred was raised now based on the fact that we've got deals in the pipeline that I would say are in the likely category where we like the returns and we'd certainly be accretive to the cost of the preferred. I think the challenge was getting too specific on timing is that everything we do is ultimately a privately negotiated transaction. So you can't be completely certain with timing. But I would say the timing of the raise was based on having some, a fairly robust pipeline where we think there'll be some closings early -- late Q3 into Q4 and get the capital deployed fairly quickly.

[Operator Instructions] Your next question comes from Vivek Agrawal with Wells Fargo.

With the new capital that's been raised with the preferred, are you going to look to add the duration in the portfolio?

I mean look, consistent with previous comments that we've made, we've been working for the last, call it, 6 to 9 months to try and find deals with good duration. It's always a balance between things that we think are attractive risk-adjusted returns and those allow us -- that allow us to lengthen the duration of the portfolio overall. We're at about 3 years today. The market is generally a mix of, call it, 3- to 7-year deals, the Chapel Hill deal was obviously attractive because it allowed us to get money out for 10 years. But look, in the environment we're in today, if we could get, call it, good double-digit returns that allow us to extend the portfolio, we're comfortable taking that duration for those types of returns and are certainly working on a handful of transactions that would allow us to extend the duration.

[Operator Instructions] And there are no further questions at this time.

Thank you very much, operator, and thanks, everybody for joining the call this morning.